Two Steps Forward – One Step Backwards. Wait For Support and Buy the Dip.

March 20, 2012
Author: Peter Stolcers, Founder of OneOption
Author
Pete

There’s an old adage that the market takes the stairs up and the elevator down. The S&P 500 has broken out to new multi-year highs and the momentum clearly favors the upside. However, don’t expect any explosive rallies. This move will be very contained and orderly. Along the way, we will have an occasional “speed bump”.

Two weeks ago, the S&P 500 declined 24 points in one day. That was the biggest drop in 2012 and it reminded us to be prudent. Asset Managers jumped on the opportunity and it turned out to be a one-day event. This morning, the S&P 500 is down nine points in pre-open trading.

BHP said that iron ore demand in China is flattening out. They see single-digit growth in coming months and that spooked investors. China’s market was down 1%. This news has been circulated before and it doesn’t deserve the attention it is getting. China’s economic activity has been relatively soft in recent months.

This Thursday, China and Europe will release their flash PMI’s. These are the two most important economic releases of the week. In February, China’s PMI rose above 50 and if it can build on that, the market will rally. The Peoples Bank of China stands ready to lower bank reserve requirements now that inflation (3.2%) is contained. Dismal results are already factored in for Europe and any surprise favors the upside.

This morning, US housing starts fell more than expected. That was offset by an increase in building permits (3 1/2 year high). The domestic economic releases are very light this week and they won’t have much of a market impact.

US economic conditions are improving. The Unemployment Report, ADP, ISM Manufacturing and the GDP all exceeded estimates. Initial jobless claims continue to decline on a weekly basis and that bodes well for sustained economic growth.

FedEx will post its earnings on Thursday. It is an economic barometer and any positive guidance will provide spark for the transportation sector. According to Dow Theory, these stocks need to lead the rally and they have been sluggish.

It’s hard to believe that Q1 earnings season is only a few weeks away. For two straight years, stocks have rallied ahead of earnings announcements. Asset Managers will bid for stocks and any pullback will be brief and shallow.

European credit concerns weighed the market down during 2010 and 2011. That dark cloud has temporarily parted and interest rates in Europe are declining. Banks tapped the ECB for €1 trillion and they will support short-term sovereign bond auctions. The bank stress test in the US exceeded expectations and financial stocks are rebounding.

Stock valuations are attractive and the S&P 500 is trading at a forward P/E of 14. We will continue to see a rotation out of bonds and high yield dividend stocks as investors favor growth. More than $6 trillion is parked in US Treasuries and this reallocation is just getting started. The ECB can launch LTRO3 if conditions deteriorate (interest rates creep higher) and I don’t believe credit concerns will be an issue during the next three months.

We can expect a few setbacks as the market grinds higher. Economic activity in China/Europe could be an issue and high gasoline prices could also raise inflation concerns. The market will move higher but the gains will be hard-fought. Don’t over-extend yourself.

I am long calls but I only have 40% of my normal allocation committed to the market. As we grind higher, I will take profits. If we get a pullback, I have plenty of firepower to “buy the dip”. This approach gives me the most flexibility.

Cyclical stocks have not participated in the rally and I believe that they will start to move higher in the next week or two. Look for strong sectors and try to play the rotation.

Bears will flex their muscles this morning and Asset Managers will pull their bids so that they can gauge the selling pressure. Wait for support and add to call positions. I view this pullback as an opportunity, not a setback. If the selling gains traction, the market should find support at the breakout SPY 138. I don’t believe the market will get that low before buyers step in.

Look for an early low and a gradual rebound. The market won’t advance much until we get the PMI numbers from China and Europe on Thursday.
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